Don’t ignore the emerging market debt bubble

IT WAS the worst week for US markets since August last week, and now both the Dow Jones Industrial Average and the S&P 500 are on track for a losing year in 2015. The euro is trading at its lowest levels in six months, and investors are selling on almost a 90 per cent certainty that the US Federal Reserve will raise interest rates next month for the first time in close to 10 years.

But let’s keep things in perspective – US markets are more or less only 5 per cent away from the record highs reached during the summer. The most concerning issue I see arising from an impending hike in US interest rates is the debt bubble in emerging market economies.

Emerging markets have gorged on cheap debt for the past decade, swelling to 195 per cent of GDP on average up from 150 per cent in 2009. What happens when they have to pay more (higher interest rates) to continue borrowing, especially when much of this debt is denominated in dollars?

It may get especially ugly for those countries that spend more outside their borders than they take in. Luckily, the biggest of them all — China – takes in more money from selling its goods overseas and foreign investment dollars coming in than it deploys outside of the country (in other words it runs a current account surplus).

But don’t forget the events of 1997. Back then, it was a tiny nation called Thailand and its currency the Thai baht, seldom internationally traded at the time, which caused the Asian financial crisis. And given we are in such a globally connected world, when one part catches the flu, the rest could suffer from a protracted cold.

In Europe, meanwhile, this week the focus will naturally be on the traumatic and tragic events in Paris. Security dominated all other topics at the G20 meeting of the world’s biggest economies in Turkey this weekend.

But will the horrific events have a lasting economic impact? The majority of analysts say no. Markets were already heading in a downward drift when the news unfolded on Friday. The terrorist attacks just pushed investors to reduce risk even further.

But the events in Paris could have a significant political impact. Given that the refugee debate was already front and centre for European policy-makers, the attacks could add more fuel to the fire and heighten the risk that the EU might break apart. UK Prime Minister David Cameron may even be more forceful in his threat to recommend Britain leaves the EU to keep the country safe. Will German Chancellor Angela Merkel be able to finish her term with her country so divided on allowing refugees into Germany? Perhaps France’s President Francois Hollande might be able to catch a second supportive political wind by being a strong leader in his nation’s time of need.